- Transaction evidence suggests buyers have been pricing in unprecedented income growth for U.S. industrial property.
- Record-low vacancy has driven strong increases in market rents, which have shaped actual and expected income growth.
- Risks remain, though, and investors may need to exercise caution when underwriting expected income growth.
801 Boxwood Road in Wilmington, Delaware, may not have the same prominence in public consciousness as more famous buildings like the Willis Tower or Mall of America, but as a 3.9-million-square-foot Amazon fulfillment center, it is arguably helping transform the way we live just as much as supertall office towers and megamalls once did. The e-commerce revolution is also having an effect on portfolios of commercial real estate, with industrial allocations in the MSCI Global Quarterly Property Index growing from 15% a decade ago to 33% as of June 2022. Industrial investment has benefited in recent years from the growth of online shopping, a trend that was turbocharged during the pandemic. This trend helped drive demand for logistics and warehousing assets, putting downward pressure on cap rates and boosting returns. But are expectations for the sector still grounded?
A growing disconnect in income growth
One way we can evaluate whether expectations are well grounded is by comparing historical growth in net operating income (NOI) from the MSCI U.S. Quarterly Property Index to a measure of transaction-implied income growth.1 What the results reveal is that transaction-implied income growth has historically tracked reasonably well against actual NOI growth, but over recent quarters a growing disconnect has emerged.
Transaction-implied income growth outstripped actual income growth
Transaction-implied income growth reached almost 23% in June. While actual NOI growth has been trending up over the last decade, and reached a 21-year high of 9.6% in the second quarter, it is still well below what the market seems to be pricing into recent transactions.
Buyers appear to be pricing in anticipated rent growth
An explanation for the disconnect between actual NOI growth and transaction-implied income growth appears to lie in a growing divergence between in-place and market-based industrial rents. Data from MSCI’s U.S. IRIS benchmark (a benchmark for rental information) shows a dramatic spike in reversionary potential (the theoretical change in income that could be achieved if in-place rents were brought to market) over the 12 months to June 2022.
Strong growth in market rental value has driven higher rental-reversion potential
Market rental value per square foot increased by 31% in the year to June 2022 — versus in-place rent per square foot, which increased 6% over the same period. This rapid acceleration in market rental value drove the reversionary potential from +8% in June 2021 to +34% in June 2022. This spike in under-renting matches the spike in transaction-implied income growth, suggesting that buyers may be pricing in expected reversionary income growth.
The hunt for ‘growth’ assets
With rapid growth in market rents, remaining lease term has become an important driver of industrial returns, as it influences how rapidly rents can be adjusted to market. Assets with shorter weighted-average lease terms are in theory able to capture positive reversionary potential faster than assets with longer weighted-average lease terms, which may remain rented at under-market rates for longer. The effect of this divergence is visible in industrial’s total returns. For assets with top-quartile (longer — nine years on average) remaining lease terms, total returns were 36.5% in the year to June 2022, but assets with bottom-quartile (shorter — two years on average) remaining lease terms achieved a 62.6% total return over the same period.
Shorter-leased industrial properties have outperformed
While income-growth expectations are built on the back of expected long-term trends, investors may still need to exercise caution. One of the drivers of strong market rental-value growth has been record-low industrial vacancy rates, which have fallen below 3% in the MSCI U.S. Quarterly Property Index in recent quarters. (Vacancy rates in some markets, such as California’s Inland Empire, are even lower.) But the industrial sector has historically had elastic supply compared to some other property types; new industrial properties are typically easier to bring online than, say, offices in central business districts. This is one factor that has historically limited income growth for the sector.
Industrial vacancy has fallen to historic lows
With inflation remaining stubbornly persistent, and the Federal Reserve aggressively tightening monetary policy, there are other growth risks, such as an economic slowdown or recession, that could put downward pressure on market rents.
With retail still facing headwinds from online shopping and office contending with uncertainty over remote work, the industrial sector could continue to attract attention. However, investors will still need to be aware of potential downside risks and exercise caution when underwriting income-growth expectations.
1We estimate transaction-implied income growth using the MSCI Real Capital Analytics Hedonic Series for cap rates and pricing, and it can be thought of as the amount of growth in prices not explained by cap-rate compression and therefore attributable to income growth.